Does it pay to challenge the SEC over non-GAAP financial measures?

As discussed in this article, the WSJ engaged Audit Analytics to perform an analysis of SEC comment letters and company responses regarding the use of non-GAAP financial measures. What did they find? Companies are winning the argument more often than you might think.

As you probably recall, as more and more companies began to prominently feature non-GAAP measures — and often more prominently than related GAAP measures — non-GAAP measures came under increased scrutiny and a barrage of criticism from the SEC staff, including threats of a crackdown, amid concerns that these measures were sometimes dodgy and potentially misleading to investors. Then, in May 2016, the staff issued new guidance (see this PubCo post), which emphasized, among other things, the need to present GAAP measures with equal or greater prominence relative to the non-GAAP measures. The guidance also advised companies to avoid cherry-picking of adjustments within a non-GAAP measure, the use of non-GAAP measures inconsistently between periods, adjustments to remove normal recurring cash operating expenses that are necessary to operate the business, replacement of important accounting principles with alternate accounting models that do not conform to the company’s business, and identifying excluded charges as non-recurring when the nature of the charge or gain is such that it is reasonably likely to recur within two years or there was a similar charge or gain within the prior two years.

As discussed in this PubCo post, shortly after the staff issued that guidance, Audit Analytics conducted another analysis for the WSJ, showing that companies seemed to be following the staff’s advice: over 25% of the companies in the S&P 500 index had shifted their presentations to put GAAP at the top of their quarterly earnings releases and 81% made GAAP numbers most prominent, compared with only 52% for the prior quarterly earnings releases. Some companies even dropped non-GAAP measures altogether. Moreover, that early analysis showed that, of the 42 companies that had received comments about substituting “tailored revenue metrics” in lieu of the applicable GAAP measure, 29 had “changed their presentation of results to satisfy the SEC’s concerns.” The staff declared a “win.” (See this PubCo post.)

SideBar: Commenting on the staff’s guidance in 2016, Corp Fin Chief Accountant Mark Kronforst indicated that, for companies attempting to challenge the staff’s guidance with regard to the use of individually tailored revenue recognition and measurement methods instead of GAAP, “the bar was high.” The Staff’s view was that these measures could be misleading under Rule 100(b) of Reg G. However, he said, the guidance did not preclude companies from reporting “bookings” and “billings,” so long as they were properly characterized as such. In his view, those measures could be useful and were not NGFMs — they reported facts, not adjustments from revenue. (See this PubCo post.)

More recently, however, compliance with the guidance that concerned more than placement on the page — and that involved nuance, judgment and complexity — seems to have presented more of a challenge. Some companies that resisted making a change suggested by the guidance heard from the staff about that decision.

To assess outcomes in connection with staff comments on non-GAAP measures, Audit Analytics looked at staff comments and company responses for 51 companies. It determined that, for 35 of those companies, “the SEC backed down and concluded its conversations with the company without forcing a significant change to its adjusted earnings presentation.”

One area that seemed to draw attention was whether an expense was an unusual event, and thus could be the subject of a non-GAAP adjustment, or was instead a normal recurring cash operating expense necessary to operate the business, which the staff believes should not be excluded. In particular, non-GAAP exclusions of restructuring costs were questioned as potentially misleading — even when they were not characterized as “non-recurring”— on the basis that, in light of the frequency or duration of the companies’ restructurings, the costs could reflect regular business expenses that should not be excluded. In many of these cases, the companies were able to successfully argue that the expenses or charges were not adjustments to remove normal recurring cash operating expenses necessary to operate the businesses or otherwise part of routine operations, but rather were unique charges that skewed the comparability of operating results. In some cases, companies contended that the same charges were excluded for internal purposes, such as decision-making and forecasting by management and assessment of trends and operating performance.

One way to approach non-GAAP measures advocated by a PwC partner in the article was for companies to “establish a policy for how they calculate non-GAAP figures to ensure the practice is consistent from one period to another…. Executives should work through the nuance and judgment and be prepared to defend it to the audit committee. ‘That makes responding to a comment letter easier because you’ve talked through why it is you’ve made the adjustment,’ [she] said.” In their responses to SEC comments, some companies have referred to their internal policies, noting review by their audit committees and adverting to the benefits of consistent application of their internal standards.

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